Regulatory margin

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BIS final paper on margin for uncleared derivatives

In March 2015, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published its final report, including a policy framework on uncleared derivatives margin.

Cheeky summary

BIS’s basic idea was to reduce systemic risk in the OTC derivatives markets by requiring market participants to exchange initial margin and variation margin, at the same time promoting clearing of standardised derivatives and aligning the market participants’ incentives — in other words, by disincentivising OTC derivatives.

Scope: The document imposes margin requirements on all financial firms and systemically important non-financial entities that trade over-the-counter swaps, setting out criteria that might exclude counterparties that pose low systemic risk, such as sovereigns, central banks and supranationals — you have to screw your eyes up for a while to figure out how sovereigns and central banks don’t pose systemic risks, but still — low-risk transactions such as intragroup transactions.

Margin calculation and exchange: The document sets out the methods and standards for calculating and exchanging initial margin — collateral required to cover the potential future exposure to market value fluctuations and variation margin — collateral relecting changes in current market exposure since inception.

Eligible collateral: The document sets out eligibility criteria for initial and variation margin and specifies applicable haircuts under different levels of market stress.

Segregation and rehypothecation: The document establishes rules for segregating initial margin from the collecting party’s insolvency and restricting reuse of initial margin.

Interaction with other standards and regimes: The document discusses the interaction of margin requirements with capital requirements for counterparty credit risk, the liquidity coverage ratio and the net stable funding ratio, bank recovery and resolution frameworks, and the cross-border application and implementation of the margin requirements.

Commentary

The paper has the following resting propositions:

1. Centrally cleared standardised derivatives — exchange-traded futures and options — are transparent, liquid and good; private, bespoke, non-intermediated contracts are opaque, incomprehensible and bad.
2. Large, interconnected institutions are intrinsically dangerous. Horcrux alert: Lehman Brothers. Cognitive dissonance alert: There is no larger, more interconnected financial institution than a central clearinghouse.
3. There is a form-over-substance assumption here: that what matters is the format of a financial instrument and not its economic effect. There is nothing intrinsically dangerous about the ISDA format, nor an over-the-counter transaction: customers lend to banks (in the form of deposits) and banks lend to customers (in the form of loans) over the counter all the time. No one is suggesting margining those transactions.

Posting variation margin to customers may reduce the credit risk proposed by banks, but also reduce their available liquidity in terms of “high-quality liquid assets” available to meet liquidity calls in stress scenarios. This may affect their LCR and their ability to meet their payment obligations in stress